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Taleb raises a lot of valid concerns about the state of mathematical finance. You wouldn't believe the number of financial models that assume normal or log-norm

Taleb raises a lot of valid concerns about the state of mathematical finance. You wouldn't believe the number of financial models that assume normal or log-normal returns, despite a vast amount of evidence to the contrary. Value at Risk (VaR) is a terribly deficient risk metric, and I've never met anyone who actually believes that Black-Scholes is an accurate model for predicting options prices, yet both of these are widely used in the financial industry. My problem with Taleb and all the attention he's been getting lately because of the financial crisis is that I think it's a logical jump to go from those criticisms to "these models are bad, because of black swans". Black swans are defined as unpredictable random events with large impact. 9/11 was a black swan, but I don't think that the financial crisis we're seeing today is a result of a black swan. Insurers ignored systemic risk and over leveraged based on bad asset pricing, but were those assets priced poorly because of black swans? I think that's a tough argument to make, because mortgage foreclosures don't seem nearly as unpredictable as say, terrorists flying airplanes into buildings. There also seems to be a bit of observation bias in concluding that events are black swans. Prediction markets can't be right 100% of the time. To quote the article: "What does it mean to say such a prediction is right or wrong? In 2008, the day before John McCain was scheduled to announce his VP choice, the Intrade prediction market gave Sarah Palin a 4% chance. Was this right or wrong? Unlikely events will sometimes happen just by chance."

yters 18y ago
What other models can they use, though? Every other distribution assumes even more about the problem domain, and would thus correlate even worse with black swans. Sounds kind of like a no free lunch theorem for finance. Anyways, do you know if anyone is trying to come up with something better?
- thomaspaine 18y ago
  There are other types of distributions which fit black swan type data better, such as power-law distributions, Gumbel distribution, etc. I don't know if research in extreme value theory is still a hot topic, but it tries to address these problems. Here is a paper on risk management and extreme value theory: http://tinyurl.com/aa7t6m http://tinyurl.com/aa7t6m Here is a nice paper on risk measures, and points out some of the problems with VaR: http://tinyurl.com/ar3336 http://tinyurl.com/ar3336 My apologies if you're unable to grok the contents of these papers...they're both a little technical but I can't think of anything off the top of my head that's more accessible.
MaysonL 18y ago
My problem with Taleb and all the attention he's been getting lately because of the financial crisis is that I think it's a logical jump to go from those criticisms to "these models are bad, because of black swans". These models are bad because the companies that have been bet on their accuracy go bust. They go bust because they assume that the probability of "black swans" such as housing prices throughout the country all going down at the same time is vanishingly small when it isn't.
mstoehr 18y ago
The orthodox school of thought in financial economics was the efficient market hypothesis, which more or less states that the best valuation on current assets is the market price. I suppose there is something to be said for pointing out that the "best valuation" may not be very good. Taleb certainly wasn't the first to bring this up, but we probably aren't worse off for being reminded of that fact.
mattobrien 18y ago
Taleb has not claimed that the current crisis is a Black Swan; in fact, quite the opposite. While this crisis has thrust his ideas into the spotlight, he has maintained in interviews that our financial crisis was entirely predictable (and he, among a handful of other prominent economists, did in fact predict it).
steveplace 18y ago
Black-Scholes is an accurate model for predicting options prices, Hi, options guy here. I don't think that model has been used for predicting in a long time. It's now used for pricing. Back in the day before computers couldn't run calculations, market makers could arb using these models, but due to the liquidity of the market it's much harder to now. Also, BS assumes european-style options, which is not the case on nearly all options trading. I personally use bjerksund stensland as a model, but just for pricing.

yters 18y ago

What other models can they use, though? Every other distribution assumes even more about the problem domain, and would thus correlate even worse with black swans. Sounds kind of like a no free lunch theorem for finance. Anyways, do you know if anyone is trying to come up with something better?

thomaspaine 18y ago
There are other types of distributions which fit black swan type data better, such as power-law distributions, Gumbel distribution, etc. I don't know if research in extreme value theory is still a hot topic, but it tries to address these problems. Here is a paper on risk management and extreme value theory: http://tinyurl.com/aa7t6m http://tinyurl.com/aa7t6m Here is a nice paper on risk measures, and points out some of the problems with VaR: http://tinyurl.com/ar3336 http://tinyurl.com/ar3336 My apologies if you're unable to grok the contents of these papers...they're both a little technical but I can't think of anything off the top of my head that's more accessible.

MaysonL 18y ago

My problem with Taleb and all the attention he's been getting lately because of the financial crisis is that I think it's a logical jump to go from those criticisms to "these models are bad, because of black swans". These models are bad because the companies that have been bet on their accuracy go bust. They go bust because they assume that the probability of "black swans" such as housing prices throughout the country all going down at the same time is vanishingly small when it isn't.

mstoehr 18y ago

The orthodox school of thought in financial economics was the efficient market hypothesis, which more or less states that the best valuation on current assets is the market price. I suppose there is something to be said for pointing out that the "best valuation" may not be very good. Taleb certainly wasn't the first to bring this up, but we probably aren't worse off for being reminded of that fact.

mattobrien 18y ago

Taleb has not claimed that the current crisis is a Black Swan; in fact, quite the opposite. While this crisis has thrust his ideas into the spotlight, he has maintained in interviews that our financial crisis was entirely predictable (and he, among a handful of other prominent economists, did in fact predict it).

steveplace 18y ago

Black-Scholes is an accurate model for predicting options prices, Hi, options guy here. I don't think that model has been used for predicting in a long time. It's now used for pricing. Back in the day before computers couldn't run calculations, market makers could arb using these models, but due to the liquidity of the market it's much harder to now. Also, BS assumes european-style options, which is not the case on nearly all options trading. I personally use bjerksund stensland as a model, but just for pricing.